Christine Benz: Hi. I’m Christine Benz for Morningstar.com. I recently visited Vanguard, where I sat down with Chris Philips, a senior analyst in the firm's investment strategy group. We discussed some of the noncore bond types that investors have been flocking to over the past several years.

Chris, thank you so much for being here.

Chris Philips: Absolutely. Thanks for having me.

Benz: When we look at fund flows, and we have a lot of data at Morningstar that looks at investor behavior and what they’ve been buying, we’ve been seeing that within the fixed-income space, investors have a very strong appetite for high-income producers. They’ve been looking to some of these noncore categories. I’d like to cycle through some of them.

Global fixed income is one; we haven’t seen flows there be quite as robust. But Vanguard recently did add global fixed-income exposure to a number of its products, including the Target Retirement lineup. I’d like to discuss the pros and cons of that asset class and what role you see it playing in investors’ portfolios.

Philips: It's actually the largest asset class that’s out there. Some investors might not realize that, but when you think about this four primary asset classes, U.S. and non-U.S. bonds, U.S. and non-U.S. stocks, non-U.S. bonds is the largest asset class out there. So we think it is absolutely relevant to talk about it. The biggest question is what type of exposure do you get and how do you go about implementing it in your portfolio? When we actually look at investors' portfolios, most investors have much less exposure to non-U.S. bonds than they have to U.S. bonds, and there are various reasons why that could be a good thing. But what we also know is that most investors will use international fixed income the way they use international equities. By that I mean they actually have currency exposure in their portfolio.

Benz: They buy an unhedged bond fund.

Philips: Exactly, and that tends to be the easiest, most direct way of doing it because you don't have to worry about the hedging cost or the potential operational challenges of hedging in the portfolio. But what it does do is it leads to perhaps some unintended consequences when you think of diversification. When we think about the role of bonds in a portfolio, we view them as a vehicle to help diversify the risky assets that you already have. Now, whether that's stocks-only, whether it’s stocks, real estate, other types of investments that you have, we view fixed income as the ballast to all that volatility.

Currency and foreign exchange rates tend to be a lot more volatile than bonds, less volatile than equities, and somewhere in the middle between those two. The challenge, though, is that by having that exposure to foreign currency in your fixed-income portfolio, you now have something that acts more like stocks than bonds, and it may not actually be a diversifier that you intend it to be.

Benz: Vanguard's choice in terms of implementing foreign bonds into the lineup was actually to use fully hedged funds, and you incorporated them across the target-date lineup. About how much of the fixed-income weighting within those target-date funds is foreign fixed income?

Philips: We targeted 20% of the fixed-income exposure to be in non-U.S. bonds, and that is consistent whether you are in the 2050 fund or in the income fund. It's the fixed income to equity exposure that changes. But within equities we have a constant 30% exposure to international equities, and within bonds we have a constant 20% exposure to international bonds.

Benz: How did you arrive at that 20%?

Philips: That's actually an interesting question, and I would love to be able to sit here and say there is a mathematical quantitative reason for that. There is some analysis that goes into driving that. But the reality is, if you look at the numbers, the numbers, whether you use pure market cap--market cap would, say, be around 60%--if you use a mean-variance-type framework, it might actually say 90% to 100% should actually be in foreign bonds. But then we have the reality that most investors might not tolerate that much foreign fixed-income exposure. And having U.S. fixed-income exposure when most of your liabilities, if not all of them, are going to be in dollars--they are going to be linked to U.S. inflation, U.S. interest rates--there has to be some stepping back from that significant allocation. We start off by saying that we want more than none. We felt like 30% to 40% was probably a little aggressive for the first-time move, and so essentially we landed on 20% as a great balance between opportunity for diversification, cost of implementation, and the reality of a very significant home bias for most U.S. investors.

Benz: What are the extra risks that investors should be aware of that might come along with a foreign bond weighting, even if it is one that’s fully hedged?

Philips: The most obvious risk would be political. If you use a situation like Greece--and Greece has obviously been in the headlines much of the last three to five years--but that is a very real risk that you get with exposure to foreign countries. Now, does that mean that’s a reason not to invest in it? I would say that's not a reason at all, but something you should be aware of. Today we, obviously, have a resolution for the debt ceiling in the U.S. and some good news there, but there have been questions about U.S. interest rates and the U.S. fiscal situation. If investors at all worried about that, having that global diversification can be a very good benefit in their portfolios.

Benz: Another category where we’ve seen a lot of investor interest has been this emerging-markets bond space. We’ve seen flows into the category just be quite astronomical over the past several years. Let's talk about that category, the pros and cons. That is one area where Vanguard really hasn't gone in. What would you say to investors who are looking at that category right now?

Philips: Emerging-markets bonds is an interesting classification of investment. I think there are some perceptions, and I think there are some realities out there. I think the biggest misperception the investors have is that emerging-markets bonds are all risky. When you look at the classification of a lot of emerging-markets bonds, most of them are actually investment-grade-rated, which not a lot of investors realize that. Yes, they come with higher yield, so there is some risk there. But they are considered investment-grade and not necessarily junk. There are certainly some that would be junk out there.

The other consideration is whether you go into local currency-denominated emerging-markets bonds or ones that are denominated in U.S. dollars. And there are different implications and different reasons why you might choose one or the other or both in your portfolio. I think the biggest thing to be aware of, though, with emerging-markets bonds is, just like anything, there is no free lunch. So if we’re reallocating from diversified U.S. investment-grade fixed income, whether it's a broadly diversified passive fund or an active fund, whatever the choice the investor made is and moving into an emerging-markets fund, you're absolutely adding risk in the portfolio. In emerging markets it tends to actually take the flavor of equity-type risk, and so they are very much correlated to emerging-markets equities.

Benz: In terms of allocations, would you recommend that investors take sort of a light touch here, maybe not go at all? Or what's your take on that particular question of allocation?

Philips: Emerging-markets bonds are a fairly small portion of the global bond market. So if you think in terms of initial framework for investing, the market proportional allocation would be somewhere around 1% of the bond market is in emerging-markets bonds. That’s not very much. So if we think about what a meaningful allocation for an investor’s portfolio would be to move the dial. If you're talking 5%, 10% of your portfolio in something like emerging-markets bonds, that can come with significant risk exposures, and something that we actually looked at would be what is the impact to an investor’s portfolio. What we found was that essentially the more you have, the greater the expected return and the greater the expected risk of your portfolio. So you don't get a traditional curvature to an efficient frontier where you end up with greater return with less risk or some type of optimal structure. It really is, the more you have, the riskier your portfolio and you should expect more return for it. But it’s not a free lunch, and that risk can come in terms of loss. In a global financial crisis, emerging-markets bonds got hurt a lot more than diversified U.S. fixed income.

Benz: We even saw during the rate shock that we had earlier this summer emerging-markets bonds took it pretty hard. Why was that?

Philips: So there was a lot of conversation out there, the talk about the Fed starting tapering the bond-purchase program they have out there. That really drove a lot of investor, I think the term is being coined, animal spirits, that if the Fed takes away the punchbowl or starts taking away the punchbowl, what’s this going to do to the risk securities out there that investors have really gone into to seek that yield. So you saw that sell-off in emerging-markets bonds; you saw some sell-offs in emerging-markets equities over the last several months and up until probably the last several weeks really. But there's a lot of that behavioral and investor sentiment that can get wrapped up in the near-term performance of a lot of these more segmented asset classes.

Benz: Junk bonds are another area, and sort of a subarea would be the bank-loan category in particular. That’s where we’ve seen the flows going in a big way. What’s your take on investors adding that sort of additional credit exposure, maybe in lieu of high-quality exposure or perhaps in addition to it?

Philips: Sure. I think there are two reasons why you might look at either just general high-yield corporate funds, the kind of junk realm, or the floating-rate, the bank-loan type products. The most obvious would be seeking yield because they do come with a much greater stated yield than your traditional investment-grade type of funds. But another implication of higher yield is that you end up with lower duration and less sensitivity to interest-rate moves. So when you think in terms of the bank loan funds or floating-rate notes or these types of products that have very, very short, if any, duration exposure, in order to have some yield, you have to take on credit risk.

Now that credit risk is very, very correlated, as anyone in the industry would acknowledge, very correlated to movements of the equity market. So you are ending up changing the risk profile, the risk structure of your portfolio if you’re moving from traditional investment-grade, high-quality fixed income into a more concentrated credit-sensitive-type product. That could be a good thing; it could be a bad thing, depending on what your own risk tolerance is as an investor. But there is nothing that says just because you invest in a high-yield fund, you're guaranteed to get that higher yield.

One of the things that we actually show in some of our research is that the probability of a high-yield fund actually achieving its stated yield isn't that great when yields are at levels where they are today. The reason is because that default risk, the downgrade risk, just the credit risk itself can cause a lot of volatility in there. In terms of total returns, you might not actually achieve that yield that you think you're getting.

Benz: Here again should I think about these categories maybe as a way to limit risk in my equity portfolio, like take some of the equity portfolio and put it in these categories rather than taking part of my bond exposure and putting it into these categories? And what sort of allocation to these categories makes sense to you?

Philips: I think in terms of allocation, again, that’s going to be an investor-by-investor discussion with their own advisor, or however they make their decisions. But it is interesting to think about the role of all these assets in a portfolio. I think speaking for myself, and I think some of the others in the industry might agree that, things like emerging-markets bonds or real estate investment trusts or commodities or high-yield bonds, they're all what we consider risk assets. So you can think of them all in a similar type of bucket that you would then have your less risky or diversifying assets to work against.

So whether you're taking them away from equities and just broadening out that risk allocation, that can make sense for some investors, acknowledging that, because equities tend to be at the highest end of the risk spectrum, they should come with a highest expected return. The minute you start diversifying away from those and into things that should have lower expected return, that’s going to have implications for your portfolio, as well; more on the return side, but probably less on the risk side versus taking away from fixed income.

Benz: I’m guessing that you would say don’t use these securities in place of cash, which is what some people are worried is going on, where we’ve seen flows out of money market into some of these other categories.

Philips: Absolutely. I think that is the other side of the coin here, where if someone is in cash, but they're used to getting 3%, 4%, 5%, 6% in their cash and use as their income vehicle, all of a sudden you can't get that. So now you have a decision as someone who is spending from their portfolio, "Do I spend less?" which most people don't want to do; "Do I take on more risk?" which most people have done; or "Do I start thinking about drawing down principal; how do I allocate and think about overall spending in my portfolio?" that can be a tough conversation, as well, around principal. So that's why most people default to taking on more risk. But by moving from cash into even something like investment-grade corporate bonds, you're adding significant not just duration risk, but credit risk as well to something you that didn't have that risk before.